OFR Publishes 2015 Financial Stability Report

The Office of Financial Research recently released its 2015 Financial Stability Report which finds that “[o]verall threats to U.S. financial stability remain moderate,” but that some threats “have edged higher over the past year.” The report cites concerns about elevated credit risks, the low interest rate environment, and the resiliency of the financial system. With respect to mutual funds, the report acknowledges that “the 1940 Investment Company Act restrict the investments and financing activities of mutual funds, reducing the likelihood that such funds could spark financial market turmoil.” In addition, the OFR report applauds the recent SEC proposals regarding mutual fund reporting and liquidity. In discussing the proposed form N-PORT, the OFR finds that the form would not only help the SEC oversee funds but would also allow additional research into the risks of mutual funds. While recognizing the positive effect of the money market fund reforms as well as the SEC proposals to address other risks in the asset management industry, the OFR maintains that “mutual funds may still contribute to financial instability through contagion and spillover induced by redemptions or correlated trades.”

The OFR report expresses concerns about the bond markets, including the involvement of mutual funds therein. The paper notes that since the financial crisis, ETFs and mutual funds have become significant owners of corporate bonds. According to the OFR, the change affects market liquidity as funds trade less frequently than banks or dealers, limiting the securities available for trading. In addition, the paper discusses “window dressing,” particularly by broker-dealers that are owned by foreign banks. The paper notes that “dealers in aggregate seem to be reluctant to hold market-making inventory over a quarter-end, which may imply a reduction in bond market liquidity depth in the last days of the quarter.” As a result, “non-dealer traders of bonds, including both mutual and private funds, may get lower prices if they need to sell during this time” which “may have systemic implications, including an increased likelihood of fire-sale sell-offs or liquidity spirals.”

The OFR also expresses concern about the impact of asset managers on market volatility. The report finds that “[o]ver the last four years, asset managers shifted from buying volatility as a hedge to their risky assets to selling volatility as a means to enhance returns,” which “had the effect of not only further suppressing volatility but also increasing the potential for destabilizing losses in the event of an unexpected spike in volatility.” While asset managers have begun to switch back to long volatility, they “still account for about 20 percent of the total gross short volatility positions . . . and asset managers and leveraged funds hold a much larger concentration of short positions . . . compared to a year ago.”

The report notes concerns about emerging markets investments. The OFR finds that banks and mutual funds appear to be the largest investors in emerging markets with bank exposures estimated at $980 billion and mutual funds estimated as similar levels. The paper explains that “[t]hese direct financial exposures are sizeable enough to subject U.S. investors and institutions to material market and credit losses in the event of a broad and severe emerging market crisis, though the ultimate impact on financial stability would depend on confidence effects, indirect exposures, and any opaque linkages, all of which are difficult to estimate in advance.”

The OFR suggests that “[t]he financial system is highly complex, dynamic, and interrelated, making it exceedingly challenging to monitor developments in every corner of the system and adequately assess the probability and magnitude of all important risks.” While the report applauds the SEC’s proposal to enhance and modernize reporting and previous efforts to improve reporting, it also argued that additional information would be helpful regarding “firms’ assumptions about inflows from bank lines of credit and overdrafts from custodians.” The report suggests that voluntary pilot programs launched this year by the OFR, Federal Reserve, and the SEC to collect data on the scope, quality, and accessibility of the repurchase agreement and securities lending markets should be made permanent.

Looking specifically at ETFs, the report finds that there have been no sustained disruptions of secondary market liquidity. However, the OFR states that “risks associated with liquidity mismatches in bank loan ETFs could lead to a self-reinforcing cycle of liquidity-induced price declines.” The OFR points to the volatility in ETFs on August 24 as one example of this risk. The presence of “wide variations” in the impact of volatility on that date may mean that “[m]ore research is needed to understand why seemingly similar ETFs may experience wide variations in trading.” Further, the incident “highlights elements of the market structure, such as exchange trading rules, that may exacerbate price dislocations by inhibiting market makers from adding liquidity,” especially due to the fact that the top three market makers account for half of the reported trading volume in ETFs. The report finds that “[s]ome of the larger market makers in the ETF market also appear to gain access to liquidity by placing ETF shares as collateral in the repo market” and expressed concern that “a disruption in the dealer funding markets could affect a market maker’s ability to finance its inventory in ETF shares and decrease the amount of liquidity it provides to support ETF trading.”